Warren Buffett has a famous saying, “Only when the tide goes out do you discover who’s been swimming naked.”
Axios reports that “the COVID-19 outbreak has caused supply chain disruptions for nearly three-quarters of U.S. companies, and many are already pricing in revenue losses this year as a result, according to a special ISM survey.”
Here’s the Financial Times on March 8, 2020:
“Peter Guarraia, who leads the global supply chain practice at Bain & Co, estimated that up to 60 per cent of executives have no knowledge of the items in their supply chain beyond the tier one group.”
“Lora Cecere, founder of Supply Chain Insights, a research group, said two-thirds of businesses do not even know the locations of their second and third-tier suppliers, let alone the factory names and critical details needed to make a solid assessment.”
In the pursuit of ever cheaper inputs, American companies have put the country in a strategically difficult position.
“About 72% [sic] manufacturers of pharmaceutical ingredients supplying the U.S. are overseas, including 13% in China, according to FDA testimony last year.”
“’The problem we are facing is: What is the risk? We just don’t know,’ Pocan said in an interview.”
This is terrifying. To put things into an economic perspective using the framework developed by Frank Knight, “risk applies to situations where we do not know the outcome of a given situation, but can accurately measure the odds. Uncertainty, on the other hand, applies to situations where we cannot know all the information we need in order to set accurate odds in the first place.”
You know who doesn’t like uncertainty? Capital markets. They despise it. US equity markets entered bear market territory on March 11, even as credit markets were panicked with the yield on the 10-Year US Treasury Note trading down below 0.4%, briefly on March 9, 2020.
Corporations globally were self-insuring the risk of supply chain disruption without any real sense of how bad the checks could be that they might have to write.
Imagine if someone were willing to write hurricane insurance on a house without bothering to take the time or energy to check out where it was located, or what the history of tropical storms had been in the area, merely asking the broker about how much premium they could earn. Is it really a surprise that the homes with the highest rates were the ones in harm’s way? Or that when the Big One finally came, the collected premia didn’t come close to covering the damages?
U.S. News & World Report summed it up well:
“In a way, one central question for supply chain dynamics moving forward seems to be greed versus safety. Stockpiling, redundant suppliers – these prophylactic measures cost money, Broadman says.
“’The reality is that many of these manufacturers and retailers have experienced disruption in the past and agreed that the cost savings were worth the risk,’ says Steve Agran, a managing director with Carl Marks advisors, a middle-market investment bank and advisory service.”
What are the problems in sourcing that led us to this point and what could sourcing staff have done differently?
Sourcing Has to Change and It Has to Change Now
In the context of sourcing, full supply chain visibility means knowing who your suppliers are, who your suppliers’ suppliers are, and so on all the way through to the original input.
Let’s consider a simplified, fictitious example: a fabless analog semiconductor company called HypeCom. HypeCom designs chips and outsources manufacturing to a third party. HypeCom uses Taiwan Semiconductor as its sole Tier 1 supplier a semiconductor fabrication facility. (HypeCom isn’t big enough so they concentrate all their volume with Taiwan Semiconductor to get the best pricing.) Taiwan Semiconductor would, in turn, source blank silicon wafers from one set of companies as well as electric power and semiconductor manufacturing equipment from various other companies. These suppliers to Taiwan Semiconductor would be Tier 2 suppliers for our fabless semi company. The wafer companies would need to source sand from yet someone else who would be … a Tier 3 supplier for the fabless semiconductor company.
If HypeCom is like most companies, they know everything there is to know about Taiwan Semiconductor. They have visited the plant in Taiwan where Taiwan Semi produces the chips and spent time with senior management. They parse the quarterly financial statements and public disclosures religiously to understand and quantify the risk that Taiwan Semiconductor presents to HypeCom operations.
What they don’t do is research who Taiwan Semi sources from. They don’t know where they get the wafers or the power or the equipment. Even if they did know some of the names, they have no information or follow through in conducting a diligent investigation into these suppliers, many of whom are private companies. They haven’t asked Taiwan Semi for this information either. Everyone other than Taiwan Semi in this contrived case is said to be an “invisible” supplier, from the HypeCom perspective.
Yet, HypeCom is exposed to weaknesses in these Tier 2 and Tier 3 suppliers. What if there is a run on wafers that causes Taiwan Semi to slow down production for all its clients, giving preference to its largest, most strategically vital customers? Or, if there is a quality issue with the sand that leads to plummeting yields in the fab? This can negatively affect HypeCom’s ability to fulfill contracts to its own customers who may be using HypeCom chips to make smartphones.
These kinds of cascading, unintended consequences are indicative of complexity. Designing analog semiconductors is a complicated art at the best of times. But, HypeCom’s business exhibits a fragile vulnerability to factors not only beyond its control, but outside of its awareness.
The funny thing is it keeps on happening!
Tom Linton and Bindiya Vakil write for Harvard Business Review, “While most companies could quickly assess the impacts that Fukushima had on their direct supplies, they were blindsided by the impacts on second- and third-tier suppliers in the affected region.”
The tsunami that hit the nuclear plant in Fukushima took place on March 11, 2011.
There are even cases when people know that they are taking a risk, but they do it anyway because the upfront economics are irresistible. Consider the HypeCom sourcing officer who sole-sourced a large contract with Taiwan Semiconductor in order to concentrate volume and ensure that they get the supply when things are tight.
Those cost savings are the insurance premium HypeCom collects for the house in the Caribbean with the good view of the beach.
Why does sourcing not pursue full visibility into their supply chains?
On the face of it, there don’t seem to be any good solutions other than brute force labor. But, good procurement staff are difficult to find. Procurement departments are short-staffed. They are struggling to keep up with the massive bureaucracy that is the RFP business process. (Even then, they fall prey to “shaped” RFPs.) Depending on what they source, companies may have a ton of small suppliers, who have their own suppliers. Everyone thinks that they need to keep their cards close to the chest. There are lots of reasons.
Sometimes people just don’t comply with the procurement policies. Sourcing has become such a complicated endeavor that people end up treating it as a pro forma exercise in compliance instead of executing it the way it was intended.
It is often not about getting the right thing from the right supplier at the right price as much as it is about appearing to follow procedure.
Over time, sourcing on paper has come to look like a belts-and-suspenders process, but in practice is more of a clothing optional affair, to Buffett’s point.
Procurement expert Sigi Osagie is spot on in Spend Matters:
“Purchasing processes that are cumbersome or entail too many worthless activities drain value from Procurement’s work … If your processes (and any related systems or tools) are arduous, don’t expect high levels of compliance.”
These Kinds of Shocks Are Going to Keep Coming
The Wall Street Journal refers to the accelerating pace of global pandemics (or, at least, our heightened awareness of them) “including SARS in 2002 and 2003, Swine Flu (also known as H1N1) in 2009, MERS in 2012, Ebola in 2014-2016, Zika in 2015, and Dengue in 2016.”
“Epidemics of infectious diseases have become a regular part of the global landscape in the past quarter-century, thanks in part to economic trends including urbanization, globalization and increased human consumption of animal proteins as society becomes more prosperous, these experts say.”
“Mr. Daszak estimates pandemics could cost as much as $23.5 trillion over the next 30 years. That estimate includes not just lost economic activity and property, but also the statistical value of lost human lives.”
Investors are going to demand that companies have more robust supply chain procedures in place and they are going to incorporate an assessment of supply chain risk increasingly into corporate valuation.
Staffing Constraints Make the Problem Worse
We have written previously about the difficulties of getting the right procurement staff in place.
Combine this with the nature of the process and it’s no wonder that people cut corners. There is a reason why so many RFPs are “shaped.”
The Procurement Office has a good note on this dimension of the problem. They highlight the vicious spiral in which it is difficult to recruit, train and retain staff, leading to a constant under-staffing of procurement functions which, in turn, places even greater stress on those still in their jobs, motivating more of them to leave.
In fact, being short-staffed can lead to people to take the path of least resistance. “The GAO found that the high rate of sole-sourcing was caused by staffing shortages since the ETA had insufficient staff to properly administer the required tendering processes.”
Furthermore, “… the failure to properly staff a procurement department can have a significant adverse impact on an institution’s ability to properly manage its contracting practices. Public institutions should be careful to avoid normalizing staffing shortages since this can create a significant spiral effect of further staff departures that result in recurring cycles of sub-optimal contracting processes.”
As Baby Boomers and GenX employees approach retirement or restructuring, this may worsen, as experienced hands take their institutional knowledge with them to be replaced by a new generation of contracting staff who are impatient with bureaucracy and skeptical of bad technology.
What Would a New Approach Look Like?
The role of procurement is bound to evolve. As CIPS puts it, ““Procurement will play a key role in the management of these critical suppliers and supply chains. We might even get renamed ‘risk managers’ or ‘supply chain protectors.’”
Procurement staff will focus on complexity. “Future employees may expect to self-serve the majority of their procurement needs through established systems, leaving purchasing and supply professionals to concentrate on solving complex issues, partnering and sustainability.”
First, sourcing has to understand the problem. Staff need to be able to convert the uncertainty of an invisible supply chain into the known and understood risks of a visible supply chain. You can’t manage what you cannot see. Linton and Vakil suggest active management of company’s Tier 1 and Tier 2 suppliers with knowledge of the risks of every other supplier. Understand your exposure to get a sense for how to mitigate risks that your investors are not paying you to take. This means knowing what is happening operationally and strategically for these suppliers. Are their corporate restructurings in the sector? Is there M&A? Have companies been reporting poor financial results? Is there litigation in the sector?
This isn’t going to be free. As CIPS points out, “During this crisis, companies are recognizing the value of supplier relationship management programmes – especially when a supplier treats the organization as a priority customer if stocks are limited. However, buyers also understand the need to accept price rises as part of the relationship while the supply/demand equilibrium changes.”
Second, sourcing needs to diversify its supply. We need to redefine the concept of value-for-money to be “the right thing from the right suppliers at the right price and an appropriate level of risk.” Diversifying sourcing by spreading the business across multiple suppliers, in different geographies, is a prudent first step. Ensure that your suppliers don’t rely on the same set of Tier 2 and Tier 3 suppliers. Such overlap defeats the purpose of diversification.
Third, lay off the risk of business disruption that your firm cannot or will not manage itself to third-parties who are willing to insure your firm in consideration for a premium. Perhaps, there are “natural” hedgers out there, including in the firm’s customer base. Understand the fundamental commodity markets. Try to make sure your customers are paying you for the risk you are taking.
For example, Pilgrim’s Pride filed for bankruptcy in 2008 because their pricing model had them manage the underlying commodity price risk on behalf of their customers. Extreme volatility in the prices for key input commodities and poor management of this price risk combined to force the restructuring. When the company exited from bankruptcy, they had changed their pricing model to put the commodity price risk onto their customers (as did the other producers in the chicken industry).
Fourth, build up inventories of key parts, especially for those items that the firm must purchase on a sole source basis.
Fifth, collaborate, collaborate, collaborate.
Here is Supply Game Changer on the pervasive sense that collaboration with suppliers will become necessary, ““Sixty-five percent of procurement practitioners say procurement at their company is becoming more collaborative with suppliers, according to The Future of Procurement, Making Collaboration Pay Off, by Oxford Economics.”
Get this right and it’s not just about securing supply, it becomes a much deeper relationship. “Suppliers don’t just collaborate with you to provide a critical component or service. They also work with your engineers to help ensure costs are optimized from the buyer’s perspective as well as the supplier’s side. They may even take over the provisioning of an entire end-to-end solution. Or, co-design with your R&D team through joint research and development.”
This kind of fundamental change in the buyer-supplier relationship is enhanced by bringing in others from across the buyer firm to the conversation.
“Supplier relationships, like every aspect of the integrated supply chain, have grown increasingly complex. To achieve a competitive advantage it’s important that you approach sourcing as a strategic, systematic, cross-functional and cross-enterprise process. By establishing active collaborative relationship, sourcing evolves beyond pure transaction management to a networked, mutually beneficial partnership.”
The more that procurement staff know about the priorities of the business units, the better poised everyone is to assess and weight the risks involved. Procurement becomes strategic, as this CPO rising article points out:
“In the field of international relations, the parable of the stag hunt is used to describe and explain the dynamics, opportunities, and risks of collaboration versus competition. If countries (or in this case, buyers, line-of-business users, and suppliers) collaborate to hunt big game, like deer, the reward can be mighty: if they are successful, every member of the hunting party will take home their fair share. But if party members break off to pursue small game, like rabbits, then the rewards will be smaller and each party will be a competitor. In the realm of sourcing, going it alone may seem like the natural and rational thing to do, but the risks often outweigh the rewards. Meanwhile, sourcing organizations that have adopted a more collaborative approach are, among other things, helping to develop both new products and lower cost products, identify new markets to enter, and find M&A targets in the supply base. There’s something for every one to gain in the hunt.”
That is to say, it’s not just collaboration with suppliers, though. Collaboration with other buyers has benefits, too. There is collaborative procurement, for example, in which buyers jointly purchase items. Get this right and you can purchase in larger volume (producing greater cost savings), even as you diversify your supply, while reducing the duplication in effort of your already hard-pressed procurement staff. And you just might learn something about the category from another procurement officer at a different organization.
Sixth, find and use good quality, structured data. Data is the key to making procurement part of strategy, interfacing with other parts of the buyer enterprise, and measuring and managing sourcing risk. This article sums it up well.
“When procurement data is combined with data sources such as operations, finance and even human resources, new insights into cost control, cash flows and even fraudulent transactions can be generated. I firmly believe that the procurement team can play a central role in the data transformation of a company.”
Key to enhancing supply chain visibility and managing supplier risk is going to be data about the suppliers, located accessibly in a structured, preprocessed format. Supply Chain Brief gets it right.
“In another recent report, Gartner predicted that by 2023, organizations that don’t really tackle the issue of supplier master data management will very likely have the wrong information for half of their suppliers. When you think that many CPOs are looking to Supply Chain professionals in their organizations for data which will be used to make strategic decisions on AI, IOT, blockchain and contract automation, there is definitely a compelling reason to get this right. But it’s not easy.”
Combine this with staffing shortages and demographically driven turnover in procurement officers, the need for good quality data becomes more urgent as automation solutions can drive actionable intelligence. Per McKinsey:
“For deeper insights into purchasing data and trends, we find that advanced analytics-based systems beat traditional models every time—and the capabilities require little added investment. In most cases, all it takes is a change in mind-set. Since the potential savings from better-informed negotiations are so substantial, procurement functions have no excuse for delay.”
How Do You Implement a New Approach?
What we’re talking about here is re-engineering a business process and giving the team the tools to make that happen.
The best way to implement this change is to focus on the right technology.
At EdgeworthBox, we have taken a holistic approach to building a platform with this kind of process re-design in mind. We have layered three sets of tools on top of a marketplace that matches buyers and suppliers. The tools come from financial markets where these kinds of questions about sourcing and risk are routine for participants who trade millions of times daily in a compliance-intensive environment. We designed our 21st century app-like user experience to appeal to the changing, younger workforce.
We have a central clearinghouse for administration focused on making supplier risk management much easier for both buyers and suppliers. EdgeworthBox converts the traditional cumbersome one-to-one supplier onboarding into one-to-many vendor management using our version of a common application. Suppliers can just give potential buyers access to the relevant answers and supporting documentation with the flip of a switch. A process that IBM takes more than a month to execute (with seventy steps!) can be reduced to a minute, once the documentation is uploaded. Suppliers also benefit from only seeing relevant RFPs, avoiding the noisy stream in which they live now and missing fewer opportunities. With EdgeworthBox, a buyer can ask its Tier 1 suppliers to have their Tier 2 and Tier 3 suppliers join the platform for ready access to their underlying information.
We have a central clearinghouse for structured data, in two repositories (one private with restricted access to the firm user, and one public with government information). This data shows information about live RFPs, historic RFPs (and the interactions around them such as supplier responses), and historic contracts (including prices paid).
We have social networking to promote shared information on profile pages as well as a messaging platform that connects buyers to other buyers, suppliers to other suppliers, and buyers to suppliers. Collaborate, collaborate, collaborate. With Tier 2 and Tier 3 suppliers on the EdgeworthBox platform, particularly in times of crisis, buyers can get direct information from their full supply chain.
Our business model is such that buyers pay a small monthly SaaS fee for this functionality, a fraction of what they pay for their existing solutions. In fact, one way to think of EdgeworthBox is as a service that augments the existing investment in ERP services or cloud-based P2P or S2P systems. With the buyer’s organizational license, they get an unlimited number of seat licenses so that individuals from Finance, Operations, Product, Marketing, and Sales can join in the procurement conversation. Suppliers join for free.